Lenders Adjust 'Option ARMs' To Lessen Impact of Rising Rates

Mortgage providers are starting to tweak the features of these loans in a bid to reduce potential defaults among consumers pinched by increasing costs and softening home prices.
By: Lingling Wei: The Wall Street Journal Online
In a bid to lessen the impact of higher interest rates, mortgage lenders are starting to tweak the features of popular "option adjustable-rate" mortgages, which allow borrowers to lower their monthly payments in the early years of the loan.

The retooled mortgages, such as those rolled out recently by IndyMac Bancorp Inc. and American Home Mortgage Investment Corp., feature an extended fixed-rate period before interest charges reset and, in some cases, an option to defer repayment of principal for a longer period of time. Lenders say the new products allow borrowers more breathing room before the bigger payments come due. Some analysts, however, doubt that the new bells and whistles can actually help lenders reduce potential defaults among consumers pinched by rising interest rates and softening home prices.

The move to ease the payment burden comes at a time when the Federal Reserve and other banking regulators are sounding alarms about the potential "payment shocks" to borrowers for exotic mortgages. With "option ARMs," as such loans are called, borrowers decide every month whether to make a standard payment that involves paying interest and paying down part of the loan, an interest-only payment, or a minimum payment that usually isn't enough to cover all of the interest due. (In that case, the difference gets added to the mortgage balance.)

Often, the minimum payment remains fixed for 12 months, and each year thereafter it changes to reflect the prevailing rate the loans are pegged to. Now, with the new option mortgage offered by IndyMac, a borrower can opt to have the minimum monthly payment fixed for three years, five years or seven years, or until the principal due reaches 110% of the original balance. Once that "negative amortization" balance cap is reached, the monthly payment has to be adjusted higher.

The new option mortgage from American Home Mortgage offers a fixed rate for five years. A longer fixed-rate period makes the loan less sensitive to rising interest rates. In addition, borrowers typically have to start repaying both interest and principal once that preset balance cap is met. But IndyMac's new option-mortgage product allows borrowers to defer repayment of principal for as many as 10 years, even after the loan balance hits the 110% trigger for recasting.

The new option mortgage, designed to provide borrowers additional buffers to handle payment shocks, has become "the fastest-growing new product we rolled out," says Frank Sillman, head of IndyMac's mortgage business.